19.3 Partnership Tax Planning and Allocations

Partnership planning starts with basis

A partnership is a pass-through, but its basis rules are more fluid than an S corporation's because liabilities flow into a partner's basis. Under Section 752, an increase in a partner's share of partnership debt is a deemed cash contribution (basis up), and a decrease is a deemed cash distribution (basis down). TCP gives enough data to build a schedule and expects you to catch the omitted or misclassified item.

Outside basis versus inside basis

Outside basis is the partner's basis in the interest. Inside basis is the partnership's basis in its assets. They diverge after contributions, operations, distributions, and transfers.

Contributions and disguised sale thinking

Most property contributions are nonrecognition under Section 721. But if a partner contributes appreciated property and receives cash or debt relief under a related plan — the regulations presume a disguised sale when a distribution follows a contribution within two years — part is recharacterized as a taxable sale. Worked example: Partner contributes land (basis $40,000, FMV $100,000) and within months receives $60,000 cash. The transaction is treated as a part-sale: gain is recognized on the sale portion rather than fully deferred.

Allocations and economic effect

An allocation that differs from ownership percentages must have substantial economic effect under Section 704(b): the partnership must (1) maintain capital accounts under the rules, (2) liquidate per positive capital-account balances, and (3) require a deficit-restoration obligation or include a qualified income offset. A loss allocated to a partner who bears no economic burden is a red flag and will be reallocated to the partners' interests in the partnership.

Guaranteed payments and partner transactions

A guaranteed payment (Section 707(c)) compensates a partner for services or use of capital without regard to income. It is ordinary income to the recipient and a deduction or capitalized cost to the partnership — not a distributive share — and it can affect self-employment tax and the qualified business income deduction. Worked example: A partner entitled to a $50,000 guaranteed payment plus a 25% distributive share reports the $50,000 as ordinary income regardless of whether the partnership had a profit, and the partnership deducts the $50,000 before computing the distributive shares.

Sales and loans between a partner and partnership are related-party transactions under Section 707(a), so character, timing, and loss disallowance rules may differ from a simple distribution; a loss on a sale to a more-than-50% partner can be disallowed entirely.

Distributions and the basis-limitation gain

Partnership distributions are usually tax-free under Section 731, but two traps recur. A cash distribution exceeding outside basis triggers capital gain for the excess — and remember that a decrease in a partner's share of liabilities is a deemed cash distribution that can itself create gain. A property distribution reduces outside basis by the partnership's basis in the property, but the partner's basis in distributed property cannot exceed remaining outside basis; if it would, basis is allocated and limited. Worked example: A partner with $15,000 outside basis receives a property distribution with a $25,000 inside basis.

The partner takes the property at $15,000 (limited to outside basis) and reduces outside basis to zero; no immediate gain arises.

Hot assets and Section 751

When a partner sells an interest, Section 751 recharacterizes the portion of the gain attributable to unrealized receivables and inventory (the hot assets) as ordinary income rather than capital gain. A simulation may give a partner a $40,000 overall gain on sale, of which $15,000 is attributable to hot assets — the candidate must split $15,000 ordinary from $25,000 capital. Ignoring Section 751 is a classic error that mischaracterizes the entire gain.

Ownership changes and Section 754

On a sale of an interest, the partnership allocates income between transferor and transferee. A Section 754 election triggers a Section 743(b) step-up (or step-down) so the buyer's inside-asset share matches the price paid; a parallel Section 734(b) adjustment applies to certain distributions. Worked example: A new partner pays $250,000 for an interest with a $180,000 share of inside basis; a 754 election creates a $70,000 positive 743(b) adjustment unique to that partner, which can be depreciated or reduce the buyer's later gain.

Without the election, the buyer is taxed on appreciation that economically belongs to the seller, so the planning answer often favors making the election when a buyer pays a premium.

Exam checklist

1. Reconcile beginning to ending outside basis.
2. Include Section 752 recourse and nonrecourse debt changes.
3. Track Section 704(c) built-in gain on contributed property.
4. Separate guaranteed payments from distributive share.
5. Test special allocations against substantial economic effect.